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Bank Competition and Financial Stability

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Abstract

Under the traditional “competition-fragility” view, more bank competition erodes market power, decreases profit margins, and results in reduced franchise value that encourages bank risk taking. Under the alternative “competition-stability” view, more market power in the loan market may result in higher bank risk as the higher interest rates charged to loan customers make it harder to repay loans, and exacerbate moral hazard and adverse selection problems. The two strands of the literature need not necessarily yield opposing predictions regarding the effects of competition and market power on stability in banking. Even if market power in the loan market results in riskier loan portfolios, the overall risks of banks need not increase if banks protect their franchise values by increasing their equity capital or engaging in other risk-mitigating techniques. We test these theories by regressing measures of loan risk, bank risk, and bank equity capital on several measures of market power, as well as indicators of the business environment, using data for 8,235 banks in 23 developed nations. Our results suggest that—consistent with the traditional “competition-fragility” view—banks with a higher degree of market power also have less overall risk exposure. The data also provides some support for one element of the “competition-stability” view—that market power increases loan portfolio risk. We show that this risk may be offset in part by higher equity capital ratios.

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Notes

  1. Note that franchise value deters bank risk taking to the extent that owners believe that their ownership of the bank is at risk in the event of insolvency. If regulators are expected to forbear and leave ownership intact, the owners may not have significant incentives to control risks (Frame and White 2007).

  2. Alegria and Schaeck (2008) show that bank concentration measures are sensitive to the number of banks in each country and that their choice affects the inferences regarding the degree of competition.

  3. The list of countries and the number of banks are included in Appendix 1.

  4. Conversely, as competition in the loan market rises, Koskela and Stenbacka (2000) construct a model to show that project-holders will increase their investments because of lower lending rates. The authors argue that competition into the credit market will reduce bankruptcy risk of borrowers and conclude that there is no trade-off between lending market competition and financial fragility.

  5. We also include the volume of nonperforming loans to total equity for robustness.

  6. A potential problem with the Lerner index, as we calculate it, is that we take as given the ratio of interest expenses to deposits, W 2, which may itself embody market power in the deposit market.

  7. We thank the anonymous referee for pointing out that, in a perfectly competitive environment, a larger Lerner index can be associated with firms taking on more risk for given marginal costs.

  8. Among the tests for heterogeneity, we employ the Pagan–Hall, White/Koenker and Breusch–Pagan/Godfrey/Cook–Weisberg tests, but we only report the results of the Breusch–Pagan/Godfrey/Cook–Weisberg tests.

  9. In order to test for endogeneity, we report the results of the First Stage F test; we also report the results of the Hansen’s J test of overidentification.

  10. The developed nations correspond to the International Monetary Fund definition for “high-income” countries.

  11. First-stage regression results are provided in Appendix 2.

  12. One reason why equity capital and stability are positively related is that capital is built up through inertia as retained earnings. That is, higher ROA generates more equity capital as dividend payouts are relatively fixed (e.g., Berger 1995; Berger et al. 2008).

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Author information

Authors and Affiliations

  1. Moore School of Business, University of South Carolina, 1705 College Street, Columbia, SC, 29208, USA

    Allen N. Berger

  2. Wharton Financial Institutions Center, Philadelphia, PA, USA

    Allen N. Berger

  3. CentER—Tilburg University, Tilburg, The Netherlands

    Allen N. Berger

  4. The World Bank, Washington, DC, USA

    Leora F. Klapper

  5. Lebanese American University, Beirut, Lebanon

    Rima Turk-Ariss

Authors
  1. Allen N. Berger
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  2. Leora F. Klapper
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  3. Rima Turk-Ariss
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Corresponding author

Correspondence to Allen N. Berger.

Additional information

The authors thank an anonymous referee, Lamont Black, Tim Hannan, Tim Koch, Klaus Schaeck, and conference participants at the Financial Management Association 2008 meeting for helpful comments.

Appendices

Appendix 1

Table 6

Table 6 List of countries and number of banks
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Appendix 2

Tables 7, 8 and 9

Table 7 First-stage regressions: dependent variable is nonperforming loans to total loans
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Table 8 First-stage regressions: dependent variable is Z-index
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Table 9 First-stage regressions: dependent variable is equity to assets
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Berger, A.N., Klapper, L.F. & Turk-Ariss, R. Bank Competition and Financial Stability. J Financ Serv Res 35, 99–118 (2009). https://doi.org/10.1007/s10693-008-0050-7

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